What Can Take the Place of Fannie and Freddie?

The problem with overhauling mortgage-finance giants Fannie Mae and Freddie Mac boils down to this: many in Washington say they want to get rid of the companies, but they want to preserve many of the benefits that those companies enabled — namely, providing a steady source of relatively cheap 30-year, fixed-rate mortgages.

This explains not only why it has taken nearly six years for the overhaul debate to heat up but also why it could take several more before Washington figures out how to remake the nation’s $10 trillion mortgage market.

The leaders of the Senate Banking Committee agreed last week on a bill that promises to replace Fannie and Freddie with a new system of federal backing of certain mortgage securities. Fannie and Freddie play key roles by backing nearly half of all mortgages outstanding and nearly two-thirds of all new loans.

The bill will clarify the fault lines in the upcoming battle, which is really one over how the nation wants to rebuild its mortgage market, who will provide credit, and on what terms. While there are scores of technical questions that lawmakers need to answer, perhaps the hardest one will be this: what will take the place of the two finance giants?

“The whole plumbing of the mortgage market runs through these companies. You can’t just take these things away without having a very clear and specific view about what’s going to replace them,”said Daniel Mudd, Fannie’s former chief executive, in an interview last year.

First, a little background: Fannie and Freddie don’t actually make loans, but instead buy them from banks and other lenders. They package them into securities that are sold to other investors and provide guarantees to make investors whole when loans default.

This middleman role is important. It matches banks, which generally don’t want to get stuck holding long-term, fixed-rate investments, with different capital sources—sovereign wealth funds, pension funds, and others—that wouldn’t otherwise invest in American mortgages. The companies also set uniform standards that facilitate very liquid securities markets.

All of this helped preserve the popular 30-year, fixed-rate loan after the failures of many savings-and-loan institutions in the 1980s.

In addition to serving as mortgage guarantors, the firms also amassed over the last two decades huge investment portfolios, which helped them generate larger returns to appease shareholders. The companies claimed that these portfolios helped reduce borrowing costs for homeowners, but critics argued that they simply used their implied government guarantee to profit between the spread on those investments and the cheaper debt-funding costs.

The government was ultimately forced to rescue the companies in September 2008. As mortgage losses swelled, regulators feared that the companies might not be able to refinance the debt that they issued to fund those investment portfolios. A failed debt auction could have triggered a financial panic.

Fast forward to the present. A consensus has emerged over the last few years among economists, academics, and industry officials that says any new system should do the following:

Make the “implied” guarantee explicit and require any successors to Fannie and Freddie to pay a fee for that guarantee, as the chart up top illustrates. Successors would compete for business, selling securities and taking initial losses before any guarantee would be triggered.

Get rid of those investment portfolios, or shrink them to the point where they don’t create systemic risks. This way, the firms wouldn’t be guaranteed by the government—only their securities.

Require more capital and tighter regulation, since too little of both is what got Fannie and Freddie into trouble. Just how much capital will be required will be a major point of contention, because having more will protect taxpayers but would also raise borrowing costs.

That brings us to the trillion-dollar question stated above: who are these successors—the owners of those blue buildings in the chart above? If these firms are to be heavily capitalized, there are only so many options:

First, big banks and insurance companies could step into this role. That idea terrifies smaller lenders, of course, who are already afraid about big bank concentration. And it would exacerbate concerns about “too-big-to-fail,” as large banks would have far more control over the end-to-end loan production process than Fannie or Freddie ever did.

Second, some lawmakers have said new guarantors or private insurance companies could be created from scratch, and banks or insurance companies could be limited from becoming majority owners to limit the too-big-to-fail threat. Alternately, a government-run utility could do the job. One problem: it isn’t clear where the capital for these startups would come from.

Third, others say it would be easier to simply let Fannie and Freddie perform these functions in the new, reformed system. Of course, that doesn’t solve the too-big-to-fail problem either, as it recreates the old duopoly. Some have suggested placing limits on the firms’ size or requiring them to license their platforms to potential competitors as a partial solution.

Ultimately, the country has to decide what kind of housing policy it wants. “We have not had a debate and come down to a conclusion,” said Mr. Mudd. If the Senate bill accomplishes anything, it may finally force that debate to happen.

About Real Time Economics

Real Time Economics offers exclusive news, analysis and commentary on the U.S. and global economy, central bank policy and economics. Send news items, comments and questions to the editors and reporters below or email realtimeeconomics@wsj.com.